Lesson 2 Relevant Costing
Lesson 2 Relevant Costing
Lesson 2 Relevant Costing
Costs that differ between alternatives are relevant in a decision. All other irrelevant
costs and benefits should be ignored. In addition, managers need different costs for
different purposes.
Both approaches yield the same results. The best approach to use depends on
information availability. If the required information is available for both alternatives,
use the total approach for a better and clearer information. Using both approaches
are also better for comparison and validation of answers and solutions if enough
time is available.
1. MAKE or BUY –
Decision Criteria:
If Cost to Make ˃ Cost to Buy, then choose Buy.
If Cost to Make ˂ Cost to Buy, the choose Make.
Required:
4. Before making the final decision, Stylistic Guitar’s management will have
to assess the qualitative factors of either making or buying the guitars.
Identify some of these factors.
Answer –
a. Quality of guitars
b. Future technological advancements of the guitars
c. Commitment of guitar suppliers
d. Potential income of leasing out or using the unused
building space
ADDING or DROPPING PRODUCTS/ SEGMENTS –
Decision Criteria:
If Avoidable Fixed Costs is ˃ Contribution Margin, then choose Drop the
product or segment.
If Avoidable Fixed Costs is ˂ Contribution Margin, then choose Continue
the product or segment.
Illustration:
Ace International has three major product lines – homewares and decors,
stationery and craft, and health and beauty. The latest income statements
of the product lines are given below:
Product Line _
Homewares Stationery Health &
Total & Decors & Craft Beauty
Sales P2,500,000 P1,250,000 P750,000 P500,000
Variable expenses 1,050,000 500,000 250,000 300,000
Contribution margin P1,450,000 P 750,000 P500,000 P200,000
Fixed expenses:
Salaries & wages P 500,000 P 295,000 P125,000 P 80,000
Marketing 150,000 10,000 75,000 65,000
Utilities 20,000 5,000 5,000 10,000
Depreciation 50,000 10,000 20,000 20,000
Rentals 200,000 100,000 60,000 40,000
Insurance 30,000 20,000 5,000 5,000
General admin 300,000 150,000 90,000 60,000
Total fixed expenses P1,250,000 P 590,000 P380,000 P280,000
Net profit (loss) P 200,000 P 160,000 P120,000 (P80,000)
The management analyzed the fixed costs being charged to the three
product lines as follows:
a. Salaries and wages – represent the labor paid to employees working
directly on the products. All of the employees working in the health and
beauty would be discharged if the product line is dropped.
b. Marketing – represents the advertisements and promotions that are
specific to the product line and are avoidable if the line is dropped.
c. Utilities – represent the light, water and communication costs for the
entire company. They are allocated to the product line based on space
occupied and are not avoidable if the product line is dropped.
d. Depreciation – represents the depreciation on furniture and fixtures
used to display the various product lines which do not have resale value
even if the health and beauty is dropped.
e. Rentals – represent the noncancelable, long-term lease on the entire
building of the company which is allocated based on the area size.
f. Insurance – represents insurance premiums carried on inventories of
each three product lines. If a product line is dropped, the related
inventories will be liquidated and the premiums will decrease
accordingly.
g. General administrative – represents the costs of accounting, purchasing
and general management, which are allocated to the product lines. Such
costs will not change if the product line is dropped.
Required:
1. With the above information, should production and sale of health and
beauty be dropped?
Answer – No, dropping the product line will incur additional loss of
P50,000.
Solution –
2. Indicate some of the qualitative factors that the company must consider
before dropping the product line.
Answer –
a. Introduction of a new profitable product line
b. Attractiveness of the product line to customers
Illustration:
The Flint Fan Company is considering the addition of a new model fan, the F-
27, to its current product lines. The expected cost and revenue data for the
F-27 fan are as follows:
Annual sales 4,000 units
Unit selling price P58
Unit variable costs:
Production P34
Selling P4
Avoidable fixed costs per year:
Production P20,000
Selling P30,000
If the F-27 model is added as a new product line, it is expected that the
contribution margin of other product lines at Flint will drop by P7,000 per
year.
Required:
1. If the F-27 product line is added next year, how much is the change in
operating income?
2. What is the lowest unit selling price that could be charged for the F-27
model and still make it economically desirable for Flint to add the new
product line?
Answer – P52.25
Solution –
Incremental costs:
Variable costs P38.00
Avoidable fixed costs
( 50,000/ 4,000) 12.50
Decrease in contribution margin
of other product lines (7,000/ 4,000) 1.75
Lowest unit selling price P52.25
SELL “AS IS” or PROCESS FURTHER –
Decision Criteria:
If Incremental Revenue ˃ Incremental Cost of Processing, then choose
Process Further.
If Incremental Revenue ˂ Incremental Cost of Processing, then choose
Sell at Split-off Point
Illustration:
1. What is the overall profit if all intermediate products are processed into
final products?
Answer – P20,000
Solution –
Answer – P40,000
Solution –
Decision Criteria:
If Avoidable Fixed Costs is ˂ Contribution Margin, then choose Continue
the business operation.
If Avoidable Fixed Costs is ˃ Contribution Margin, then choose Temporary
Shutdown of the business operation.
* Shutdown costs refer to the costs, such as security and maintenance and
other unavoidable costs, that the company will continue to incur even
when there is no operation.
Illustration:
Required:
Solution –
Answer – P21,000
Solution –
Answer –
a. Shortage in materials and other supplies
b. Labor unrest
c. Effect on company’s image
d. Loss of customer’s confidence
ACCEPT OR REJECT SPECIAL SALES ORDER –
Decision Criteria:
If Special Order Price is ˃ Avoidable Costs plus Opportunity Costs, the
choose Accept the special order.
If Special Order Price is ˂ Avoidable Costs plus Opportunity Costs, the
choose Reject the special order.
If the company has excess production capacity, the minimum selling price is
equal to the relevant variable costs if the special order is rejected. If,
however, the company is operating at full production capacity (no excess
capacity for the special order), the minimum selling price is equal to the sum
of the relevant variable costs and opportunity costs (contribution margin to
be lost from regular customers).
Illustration:
Required:
1. Assuming that the company has excess capacity that is enough to
produce this special order without affecting sales to regular customers,
and the company wants to improve its profitability, the price that is
acceptable for this special, one-time order in excess of what amount?
Solution –
2. Assume that Atom is operating at full capacity and that it does not want
to incur a loss from this order, the minimum acceptable price is what
amount?
Solution –
3. Assume that the excess capacity available for the special order is only
1,000 units, so that if the order were accepted, Atom would have to
reduce sales to regular customers. What is the minimum price for this
special order?
Solution –
Incremental revenues from special order xx
Less: Incremental costs from special order:
Variable manufacturing costs
(24 + 18 + 15 + 3) 60
Opportunity cost on lost sales
(180 – 60 = 120 x 500/1,500) 40 100
Incremental profit from special order xx
4. What are the qualitative factors that Atom Company should consider
before making a decision on whether to accept or reject a special sales
order?
Answer –
Multiple Choice:
1. In decision-making case, which of the following costs is generally not relevant to the
decision?
a. Avoidable cost
b. Historical cost
c. Opportunity cost
d. Differential cost
3. Arce currently works as the fry guy at Burger Machine but is thinking of quitting his
job to attend college full time next semester. Which of the following would be
considered an opportunity cost in this decision?
a. the cost of the textbooks
b. the cost of the cola that Arce will consume during class
c. Arce's lost wages at Burger Machine
d. both A and B above
6. Which of the following is not relevant to a decision about whether to drop a segment
or not?
a. The available fixed costs direct to that segment
b. The contribution margin expected to be earned by the segment
c. The complementary effects of discontinuing the segment
d. The indirect cost allocated to the segment
7. Two or more products produced from a common input are called:
a. common costs.
b. joint products.
c. joint costs.
d. sunk costs
9. A company is considering to accept a special order which will enable it to use its
currently idle capacity. It wants to conduct a differential cost analysis so it could set
the special price for the order. In its cost analysis, which of the following should not
be included?
a. Variable overhead
b. Direct labor
c. Direct materials
d. Depreciation
10. One of Giga Core Computer’s products is Z-Card. The company currently produces
and sells 30,000 Z-Cards per month, although it has the plant capacity to produce
50,000 units per month. At the 30,000 units-per-month level of production, the
average per-unit cost of manufacturing Z-Cards is P45, consisting of P15 in variable
costs and P30 in fixed costs. Giga Core sells Z-Cards to retail stores for P90 each.
Computer Galaxy has offered to purchase 10,000 Z-Cards per month at a reduced
price. Giga Core can manufacture these additional units with no change in fixed
manufacturing costs.
In deciding whether to accept this special order from Computer Galaxy, Giga Core
should be at least concerned with:
a. what Computer Galaxy intends to do with the Z-Cards.
b. the P45 average cost of manufacturing Z-Cards.
c. the opportunity cost of not accepting the order.
d. the incremental cost of manufacturing an additional 10,000 Z-Cards per month.
CASE PROBLEMS
Case 1
Blaze Corporation makes motorcycle engines. The company’s records show the
following unit costs to manufacture part 143:
Direct materials P120
Direct labor 150
Variable overhead 200
Fixed overhead 100
Another manufacturer has offered to supply Blaze Corporation with part 143 for a cost
of P500 per unit. Blaze uses 1,000 units annually.
Required: If Blaze accepts the offer, what will be the short-run impact on
income? __________________
Case 2
Required:
A. In deciding whether to make or buy the part, what are Reflexive’s total relevant
costs to make the part? __________________
B. Which alternative (make or buy) is more desirable for Reflexive and by what
amount? __________________
C. Suppose that Reflexive is in an area of the country with high unemployment and
that it is unlikely that displaced employees will find other employment. How might
that impact your decision? __________________
Case 3
The following data pertain to the three products being produced and sold by Xenon
Corporation in a typical month:
The company’s lease contract will expire at the end of the current month, and the
lessor does not want to renew the contract. As a result, Xenon Corporation must
move to another facility. It has found a new, smaller place which the company will
start occupying next month. Since the new place is smaller, one of the products has
to be eliminated and the total allocated fixed cost would be reduced by 30%.
Required:
A. Which product should the company eliminate? __________________
B. After eliminating the appropriate product, what was the company’s net profit (loss)
before tax? __________________
Case 4
Determine which of the following products may the company process further:
Required: How much is the relevant cost in the additional processing of Product
A? __________________
Case 5
Hardwood Furnitures makes unfinished furniture for sale to customers from its own
stores. Recently, the company has been considering taking production one additional
step and finishing some of the furniture to sell as finished furniture. To analyze the
problem, the company is going to look at only one product, a very popular dining
room chair. The chair can be produced now for P650 and sells for P850 unfinished. If
the company were to finish the chair, the cost would increase to P900, but the
company could sell the finished chairs for P1,250.
Required: Should Hardwood finish the chairs or continue to sell them unfinished?
__________________
Case 6
Aster Company incurs fixed costs and expenses of P50,000. Its product sells for P100
each, and incurs variable cost per unit of P60. Current market sales yield 300 units. If
the company closes shop temporarily, fixed cost savings are estimated to amount to
P20,000, but additional costs for security and maintenance of P6,000 have to be
incurred.
Case 7
Finer Corporation has considerable excess capacity. During the month, it received a
special order at a price much lower than its regular price. The special order’s cost
sheet shows the following:
Materials P8,000
Labor 12,000
Applied factory overhead costs:
Variable 35,000
Fixed 20,000
The applied fixed factory overhead cost includes an allocated P5,000 for in-house
design costs, although no in-house design cost will be done for the special order.
Instead, the job will require the use of external designers for which the company will
incur P7,000.